Should
Kazakhstani banks compensate mortgage holders for weakened tenge?
Last week, Almaty homeowners asked the
banks to reduce the interest rate on their mortgages because the tenge had been
devalued.
This may seem to make sense, because the
devaluation will lower interest rates.
Here’s how it will happen. The central
bank’s devaluation cut by a fifth the amount of foreign
goods that a tenge can buy. Naturally, this will reduce
demand to hold the tenge rather than, say, the dollar. A fall in demand for any product – including
a currency – will reduce its price. One
might think that a tenge has no price, because you can hold it without paying
for it. But a moment’s reflection will
show that this is wrong. When you have a
tenge in hand, you give up the interest that you could have earned by putting it into a
savings account instead. So the price of
holding a tenge is the interest rate.
This will fall as demand for the tenge languishes.
Most homeowners in Kazakhstan hold
mortgages with an interest rate that had been fixed at the time of the
signing. Since the tenge was devalued
only two weeks ago, these mortgage holders will not benefit from the fall in
interest rates. Adjusting their rates
may seem a matter of simple spravedlyvoct’
(justice).
But matters are not so simple. Remarkably, mortgage holders will get the
benefit of the devaluation (namely, no
benefit), despite the fixed rate on their loans. Read on.
Lenders set the interest rate high enough
to compensate themselves for any loss of value that may occur in their money by the time
that they get it back. Suppose that the
lender thinks that the price of a pencil will rise from 100 tenge to 110 by
next year, when the loan is paid off.
Then he will charge the borrower 10 tenge on a 100-tenge loan – an
interest rate of 10%. (Of course, he
will also charge interest to compensate him for the inconvenience of doing
without his money for a year, and so on.)
The lender is not omniscient. He will not always anticipate inflation. For example, the price of a pencil may rise
to 125 tenge, not just to 110. In this
case, the borrower will gain, because he can buy a pencil for 100 tenge today
rather than 125 next year. For this
privilege, he pays only 10 tenge, so he saves 15.
Cheap
talk
And that’s what will happen to fixed-rate
mortgages. As lenders, the banks did not
anticipate that prices will rise nearly 20%.
But, in principle, that’s what will happen because of the devaluation. The fixed-rate mortgage will enable its
holder to avoid much of this inflation, because he can buy goods now while
they’re still cheap. The loser is the
bank, which will be paid back in less valuable tenge than it had lent out. You bought a pencil for 100 tenge, but the
lender will have to pay 120 for one.
Why must prices eventually rise at the same
rate – 20% -- that the tenge fell?
Because the devaluation doesn’t really change anything. The amount that we can produce doesn’t depend
on prices like the exchange rate (which is the foreign price of a tenge); it depends on what we use in production –
labor, machines, knowledge. The
devaluation doesn’t affect these resources.
If Kazakhstan
had 6 million workers before the devaluation, then it will have 6 million after
it. If we could produce 1,000 pencils
before the devaluation, then we can produce 1,000 now.
The devaluation cuts the price (in dollars)
that foreigners pay for our products, so foreign demand for our pencils will
rise. But we can produce only 1,000
pencils in all, so the amount sold to foreigners must come out of the amount
usually sold to Kazakhstanis. If Russia buys 100
more of our pencils, then Kazakhstanis must buy 100 fewer than usual. The
mechanism for this adjustment is the domestic price of the pencil. It has to rise, because pencils in Kazakhstan
are becoming more scarce.
The exception to this argument is when our economy is in recession. Suppose that we're producing only 800 pencils. Since we can produce 1,000, we can sell 100 more to foreigners without reducing the amount sold to Kazakhstanis. In that event, domestic prices won't rise by much. This argument can hold only for a while, since economies tend eventually toward full capacity. No recession lasts forever.
Need a pencil to write up your grocery list? Better buy it now. -- Leon
Taylor tayloralmaty@gmail.com
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